Monitoring XLF Prevented a Potentially Devastating Trade in the SP500

My most recent analysis regarding the S&P 500 has been proven to be inaccurate
as a failed breakout has transpired on the S&P 500 this past week. While
there is no such thing as a perfect analyst, I will openly admit that my most
recent article proved to be wrong. After I watched as the S&P 500 broke
out above the upper channel resistance area I was expecting continuation. What
transpired the following day was absolute carnage in the marketplace.

Immediately after breaking out to the upside, the S&P 500 sold off sharply
and by the end of the day on Wednesday a failed breakout was obvious. The failed
breakout trapped momentum traders as well as those watching and waiting for
the breakout to occur. The chart below illustrates the failed breakout and
the subsequent sell off that transpired the rest of the week.

Most readers likely believe that I went long when the breakout was imminent
before Tuesday's close. However, over the years I rarely chase breakouts unless
I see multiple days of price stabilization above breakout levels. Generally
a consolidation zone above a key breakout level is bullish. However, in recent
months it seems that standard technical patterns have not been working well.
In fact, chasing breakouts over the past few years could have produced some
ugly losses depending on the underlying and the timing of the breakout.

Armed with recent price action and concern for the S&P 500 giving back
gains, I did not get long the S&P 500 for members of my service at OptionsTradingSignals.com.
On Wednesday morning, I was leaning long because price action overnight was
confirming the breakout. However, when preparing my morning post for members
I noted the apathy in the financial complex.

I am constantly monitoring price action in the XLF and Wednesday morning was
no exception. The ugly price action in XLF kept me from getting involved in
a long S&P 500 trade for members. By late in the day Wednesday, the XLF
ETF had proven to be accurate and prevented losses for myself and for members
of my service. The chart of XLF at the close on Wednesday looked like this:

The point of the article is not to pat myself on the back for avoiding catastrophe,
but to illustrate to readers how important it is to monitor various aspects
of the marketplace. I generally focus on the S&P 500, the Volatility Index
(VIX), the financial complex (XLF), Russell 2000 (IWM), and the Dow Jones Transports
(IYT). Generally speaking a trader can learn a lot about the broad marketplace
by monitoring the price action in the underlying assets mentioned above. Often
times the Russell 2000 or the financial complex will throw off clues about
which direction price action favors.

At first glance, we could see the S&P 500 bounce higher in coming days
as it is coming into a key pivot low that dates back to April 18th. I am expecting
some buying support to step in around that price level as it also corresponds
with the lower bound of the recent descending channel the S&P 500 has been
trading in.

While we may see further downside, the April 18th pivot low should offer a
solid risk definition area for traders. If prices push lower, a short trade
using a stop somewhere around or above the key 1,295 price level would make
sense. Those looking to take the S&P 500 long could place a stop order
below the key 1,295 price level to define risk.

Regardless of where one believes the S&P 500 is headed, using a key support/resistance
level to place trades with limited risk makes a lot of sense currently. I will
be patient and wait for the market to throw off clues as to which direction
it favors before accepting additional risk. The primary focus for traders during
periods of wild price action should be to concentrate on reducing risk and
allowing others to do the heavy lifting. A trader or an investor can learn
a lot about the strength of an underlying asset or index by simply watching
the price action while sitting on the sidelines. The daily chart of the S&P
500 Index below illustrates the key pivot level:

Obviously the S&P 500 is coming into a key support zone, but another factor
which cannot be ignored at this point in time is the U.S. Dollar Index. On
Friday, the U.S. Dollar pushed significantly lower and most of the key commodities
such as gold, silver, and oil all closed the day near day highs and well off
of intraday lows. The U.S. Dollar Index looks vulnerable currently as its recent
rally seems to be short lived and it appears to be poised to retest the recent
lows. The daily chart of the U.S. Dollar ETF (UUP) is shown below:

The first 2 - 3 trading days of this week should provide us with clues
in terms of price action in the S&P 500 and the U.S. Dollar. If the U.S.
Dollar continues to weaken it should help support the S&P 500 and the commodity
complex. For right now I'm going to sit on the sidelines and wait for the price
action to setup before taking on additional risk. The key level to watch is
the 1,295 level on the S&P 500 and recent lows on the U.S. Dollar Index.

With QE II winding down and price action starting off the month relatively
ugly, June could shape up to be a very interesting month for investors and
traders alike. I will be out later this week with an updated analysis after
I see the price action the next few days. Until then, I would keep positions
smaller than normal and protect capital using stop orders. Anything could happen,
but this is the closest we have been to rolling over in the S&P 500 for
months. I do not have my helmet on yet, but in a couple of weeks depending
on price action I might have to wipe the dust off of it.

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J.W. Jones is an independent options trader using multiple forms of analysis
to guide his option trading strategies. Jones has an extensive background
in portfolio analysis and analytics as well as risk analysis. J.W. strives
to help traders that are missing opportunities trading options. He also commits
to writing content which is not only educational, but entertaining as well.
Regular readers will develop the knowledge and skills to trade options competently
over time. Jones focuses on writing spreads in situations where risk is clearly
defined and high potential returns can be realized.

This material should not be considered investment advice. J.W. Jones is not
a registered investment advisor. Under no circumstances should any content
from this article or the OptionsTradingSignals.com website be used or interpreted
as a recommendation to buy or sell any type of security or commodity contract.
This material is not a solicitation for a trading approach to financial markets.
Any investment decisions must in all cases be made by the reader or by his
or her registered investment advisor. This information is for educational
purposes only.